A New 401(k) Rule Lets You Withdraw Money Without Penalty. Here’s When to Do It.

Photo illustration to accompany article on special rules that allow for penalty-free 401(k) withdrawals Clint Branch and Shutterstock

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In normal times, withdrawing funds from your 401(k) account before you reach retirement age is a nonstarter in the world of personal finance advice. 

“The biggest mistake you’ll ever make,” expert Suze Orman said as recently as 2018. “Irrational,” CBS analyst Jill Schlesinger called the tactic last year in her book “The Dumb Things Smart People Do With Their Money.” “A dumb idea for any reason,” Dave Ramsey has said.

But the COVID-19 pandemic and recent stimulus legislation have suddenly changed the rules, and now some experts say the formerly unthinkable is thinkable — for certain people. 

In extremely difficult times, “a 401(k) may really be the only big resource of assets that people have available,” says Wade Pfau, professor of retirement services at the American College of Financial Services.

And as part of the stimulus package known as CARES, Congress has temporarily waived the penalties and taxes that used to discourage cash-strapped Americans from raiding their retirement accounts for short-term needs. 

Still, some things haven’t changed, like the fact that taking money from your 401(k) — where the funds are protected from bankruptcy — can have a long-term negative impact on your financial health and rob you of critical compounding years. 

Here’s what to know about taking a loan from your 401(k) right now. 

The New Normal

Thanks to the CARES Act, there are new options for withdrawing from your 401(k) without paying additional fees or taxes: The limit for 401(k) loans has been raised up to $100,000 or 100% of your vested account value, whichever is higher, and savers can take a special coronavirus-related distribution even if they’re still working.

To be clear, 401(k) holders are always free to withdraw from their 401(k) anytime. However, outside of the CARES Act provisions, withdrawals from your 401(k) would be added to your taxable income and subjected to an additional 10% tax if you’re younger than 59 and a half. There are certain exceptions, such as for withdrawals used for certain first-time home buyers and for certain higher education expenses, but there could also be additional fees depending on the exact type of plan.

For those looking to take a distribution in connection with pandemic-related hardship, the 10% fee and federal tax withholding normally imposed on early withdrawals are being waived under the CARES Act. If you repay the distribution within three years, any income tax owed will be waived. If you choose not to repay the distribution, it will be included in your taxable income, but you can spread it out over three years. 

It’s also important to note that only those most affected by coronavirus are eligible for the new rules. In order to avoid the penalties, you, your spouse, or one of your dependents must have tested positive for COVID-19, or you must have experienced “adverse financial consequences” as a result of the virus and its repercussions.  

Pro Tip

Taking money out of your 401(k) is a more viable option than it used to be, but it should still be treated as a last resort.

Who Should Withdraw From Their 401(k) Early?

Just because you qualify for a hardship-related withdrawal doesn’t mean you should take one without weighing all your other options. 

The experts we spoke with were all in agreement that withdrawing from your 401(k) shouldn’t be your first move. However, they also indicated that if you’re truly in need, then you should take advantage of the CARES Act’s allowances. 

“It should be a last resort option. People shouldn’t get carried away and start using their 401(k) assets just because they can,” Pfau says. 

Those who truly need it 

“It really comes down to need. If you need to withdraw your money, then withdraw your money. That’s really the essence of the CARES Act. It simply makes a need-based withdrawal less harmful. If you don’t need to, then don’t,” says Brandon Renfro, a financial advisor and assistant professor of finance at East Texas Baptist University. 

It’s important to consider what things will be like after you take a withdrawal and once things are back to a new normal. Under the CARES Act, you have to repay your withdrawal within three years. If you just need a withdrawal to get you through the next few months before you start earning regular paychecks again, it could be a good option. 

Those who can pay themselves back

“It’s not ‘free’ money. You have to pay it back or risk getting hit with a hefty tax bill,” says Jeff Levine, of Nerd’s Eye View, an online news source that caters to financial planners.

“Someone who may not be able to pay it back should think a little harder about whether they should tap into their retirement assets or not,” Pfau says. 

Another thing to keep in mind is how close you are to retirement. For many people, this could force them into an early retirement. “Borrowing from their 401(k) may just be a way of actually starting to take distributions for retirement earlier,” Pfau says. “You just have to recognize the trade-offs,” like not having as much money for retirement down the road. 

Those who can stomach the loss in stock value 

Because a 401(k) is an investment account, you should also consider the trade-off of missing the market rebound if you withdraw funds right now. “Any money that you borrow from your 401(k) now won’t be there when the market turns around,”  Renfro says. This would compound the adverse effects of an early 401(k) withdrawal if you don’t truly need one.   

Echoing that, Levine says many 401(k) balances have been hit hard, and taking a loan while they’re down essentially locks in the losses. 

Taking an early withdrawal from your 401(k) can have long-term adverse effects on your financial health. However, so can the ramifications of COVID-19, especially if you’ve been particularly affected by the disease. The CARES Act gives options to those who need it most. There’s no right answer, but in times of uncertainty and struggle, those options can be a life raft. 

What to Do Before Withdrawing From Your 401(k)

Even if you qualify for an early distribution, you should be wary of withdrawing from your 401(k). 

So before borrowing from your 401(k), where should you look for money? “The first and obvious place to look is liquid, cash savings,” Levine says. Ideally, everyone would have an emergency fund for situations like this. 

If you don’t have enough saved up, then take a look at your current spending — you may find areas where you can scale back to save money while times are tough.   

“Do you have a car payment or lease that you could reasonably get rid of by buying a cheaper or used car? Are you living in a rental that you could move out of and into something cheaper? Those are obviously serious steps, and just examples, but withdrawing from a 401(k) will permanently reduce your savings,” says Renfro. 

If you can’t cut anything out of your budget, you could try to get discounts. Levine suggests calling providers, like your cable and insurance companies, and explaining that you need to cut back due to coronavirus-related cash flow issues. “They’ll almost definitely offer a discount,” he says.

You could also consider taking out a small loan, “but be careful not to get yourself further behind with a high-interest debt payment,” Renfro says. 

Another option that could be worth exploring before an early 401(k) withdrawal is credit counseling. This free, no-obligation service comes with very little risk and big potential upside for people with debt. Credit counseling, typically offered through nonprofit organizations, offers an education-based approach to debt management, with a goal of empowering people to take steps to manage their credit and debt.

Something else that could be worth considering before taking advantage of hardship-related 401(k) withdrawals are the bankruptcy protections that cover most retirement accounts, including 401(k) accounts. If your financial circumstances are so severe that bankruptcy could be possible in your future, you’re probably better off leaving your 401(k) untouched and protected from creditors during bankruptcy.